February 18, 2008

CFP's Laffer Curve Video

The "Center for Freedom and Prosperity" (CFP) is a libertarian think tank that promotes a flat tax and very low tax rates. One of their prominent commentators, Cato Institute fellow Dan Mitchell, now has a video out purporting to explain the "facts" about the so-called Laffer Curve theory that tax cuts can increase tax revenues. Art Laffer, the "inventor" of the Laffer Curve diagram (if you can call a speculative bell-shaped curve drawn on a napkin an invention), calls the video "a great common sense tutorial that shows the real relationship between tax rates, taxable income and tax revenue." You can read the Center's release about the video at this link and view the video at this YouTube link.

I suspect that people who watch the video may be seduced by the apparent matter-of-fact "explanation" provided. But the Laffer Curve is simply the result of "supply-side" "trickle down" economic speculation useful for arguing for reduced taxation of the capital gains of the elite.

Mitchell points out one real fact to start out: if there is a zero tax rate, the amount of revenue taken in will be zero. Nothing else is established fact.

To establish the other end of the Laffer curve, Mtichell then states that a 100% tax rate will result in zero revenue. We can agree that in many cases a 100% tax rate would result in zero (or close to zero) tax revenues because we expect that most people would not be willing to work solely for the public good without any benefit for themselves. But that depends on an underlying assumption that the "base" being taxed is all economics from all transactions. In fact, that is not the base that is currently taxed (gifts are left out, municipal bond interest is left out, etc.). A 100% tax rate is therefore meaningless without some sense of the base that is being taxed. 100% of one half of my income is not so onerous, whereas 100% of 80% of my income seems more so and 100% of 100% of my income would be terrible (depending, of course, on the definition of "income'). The fact is, it is impossible to address the relationship between rates and revenues meaningfully without simultaneously specifying tax base and taxable periods (and even something about duration of the particular provisions). Moreover, the Laffer curve conclusion at the 100% rate also assumes that the taxpayer is getting no reasonably commensurate benefit from the government's capture of 100% of the funds otherwise earned by the taxpayer. In a socialist system, it is quite possible that the taxpayer would receive a magnificent standard of living provided by the state, which would turn the assumption on its head. Even in a capitalist system, It might also be possible to apply a temporary 100% rate, slated to return shortly to "normal" rates, over a single taxable period that would result in a huge leap in tax revenues, rather than zero revenues, where the government is understood to be motivated by an extraordinary national disaster in which all of the revenues collected will be put to the benefit of all of the citizens, in a way that individual citizens could not do under the circumstances. In other words, people in the US might be willing to work entirely for the government over a very limited time period in very limited circumstances. That is an extreme (and extremely unlikely) situation, but so is the idea that the government would ever seek 100% taxation or the conclusion that a 100% tax rate would result in no revenues whatsoever. Thus, Mitchell's statement of these various assumptions as "facts" is clearly inappropriate, since he fails to address these questions of base or time period or provision of public goods from the taxed revenues.

After purporting to establish these two "zero" endpoints, Mitchell proceeds to state (again as uncontroverted fact) that there is a single peak tax rate (the peak of the curve) that is so high that any rate higher than that will lead to more cheating, so that this peak rate is the last point where increases in tax rates can lead to increases in tax revenues. Mitchell provides as an example the 70% rate in effect when first Reagan tax cuts were installed--he claims that rate was over the peak and so led to too much tax cheating and not more revenues. Mitchell then leaves the rise and fall from that optimum as "obvious" given the endpoints and the stated peak, thus "explaining" the familiar bell-shaped Laffer Curve.

Of course, none of that is necessarily true. First, consider whether there is a single "peak" rate. There might be two peak rates in some situations--one at the low end and one at the high end--or several local peaks. There might be one fairly high peak rate with a fairly straight-line slope up to it and then a precipitous drop-off beyond that rate. furthermore, there might well not be a steadily rising relationship of rates to revenues or a steadily falling relationship at any point in the curve: the "explanation" provides no evidence to support the suggested concave shape of the curve, the assumption of continuity, or the establishment of an optimal tax rate: it merely presents a visual image as the correct answer. Different cultures and different groups of taxpayers within a culture will undoubtedly respond differently to different economic stimuli, including tax reductions or increases. The "laffer curve" represents merely one highly speculative conclusion about those responses, based on a static model that doesn't take the dynamic nature of economies, labor supplies, basic human needs, and tax systems into account.

Furthermore, in this discussion, Mitchell completely disregards a critical issue in terms of what rates are administratively feasible--the nature of tax enforcement. He never addresses the relationship between tax cheating, tax revenues, and tax enforcement. For any tax rate, the likelihood of compliance is likely substantially higher if there is better tax enforcement and the likelihood of cheating is higher if there is ineffective tax enforcement.

The visual image--Laffer's hypothesis about the relationship of tax rates to revenues, drawn on a cocktail napkin during a conversation--is then treated as a firmly established empirical fact from which various conclusions can be drawn. Mitchell proceeds to "explain" that a tax rate increase from the 15 to 20% range would bring in more revenues than a tax rate increase from the 25 to 35% range, because it is in a "lower" part of the ascending section of the Laffer bell-shaped curve and not as close to the peak where the slope of the curve is much less steep (as drawn). But the speculative nature of the Laffer curve, as described above, and the fact that it does not stem from objective observations that resulted in a substantiated mathematical formula producing the curve, means that it cannot serve as a basis for reaching real conclusions about relative merits of competing tax rates or other tax policy concerns.

Finally, we still have an inadequate understanding of the elasticity of work in response to taxes (especially given the relative inelasticity of labor supply), yet conclusions about that issue are essential to the Laffer Curve. Some people undoubtedly work more as taxes go up, some people may work less, and many people may not adjust their work at all to changes in tax rates. Some might work no matter whether there is 0% or 100% taxation. But again, since tax changes are but one part of a volatile and ever changing economic and cultural landscape, it is likely that tax rate cuts are merely one factor in overall work decisions.

Among the various conclusions stated in the video:

1) Mitchell: We "know" that there is a Laffer curve showing the relationship between tax rates and tax revenues.

Beale: Yes, there is some relationship between rates and taxes, at different points in time, that can be empirically determined and graphed. But it is not necessarily the particular relationship depicted by the "Laffer curve." And it is not necessarily a relationship that remains constant over time.

2) Mitchell: Although all tax cuts do not pay for themsleves, there is "pretty good evidence" that the Reagan rate cuts paid for themselves and that cuts in capital gains rates increase receipts.

Much of Reaganomics is myth rather than reality. The Reagan tax cuts in 1981 were followed by tax increases and then major reform to address the proliferation of loopholes. There were huge deficits because the Reagan tax cut was combined with huge defense spending. Our national debt began to balloon as a percent of gross domestic product, after years of gradually paying off the World War II debt. See this link for a great graph. Even looking at the 1986 reforms, it is clear that the Reagan rate cuts of 1986 were accompanied by significant base broadening and loophole closing. To attribute increased revenues to rate cuts is to disregard the impact of base broadening. If the Reagan rate cuts had taken place without the base broadening, tax revenues would almost certainly have decreased significantly.

Cuts in capital gains rates may tend to increase receipts (when they do) in large part because those who hold significant capital assets expect the cuts in rates to be followed by increases in rates (as has been the trend over time) and therefore choose to take advantage of lower rates to harvest losses and gains in ways that minimize their tax liabilities. That does not mean that, over the long term, cuts in capital gains rates will increase tax revenues. Much of the statistical evidence on this is highly selective--i.e., there is no objective and invarying response to capital gains tax cuts, but people who support them may claim that they increase revenues by waiting until whatever point after a capital gains cut there is some shift in the realization of capital gains resulting in increased revenues and then claiming (without much support) that the shift was caused by the rate cut.

The CBO study of Laffer curve effects also came to a significantly different conclusion than Mitchell does. Under differing assumptions about work responses to rate changes and foreign investment, it found that a 10% tax cut would only partly be made up with increased growth (ranging from 5% to 32% in the second five years after the cut), whereas the shortfall of revenues would lead to increased borrowing, resulting in substantially increased costs for the same governmental programs already deemed important. See Analysing the Economic and Budgetary Effects of a 10% Cut in Income Tax Rates, CBO, Dec. 2005.

3) Mitchell: credits, deductions and other incentives in the tax code "probably" result in unchanged incentives to work and expand the economy.

There are mixed justifications for, and expectations of, these various tax changes. Like most tax changes, it is hard to make a cause-and-effect determination because they are not enacted in isolation and any conclusions are highly speculative. Many deductions and credits are enacted to reward special interests with a "tax expenditure" type of welfare. Just as tax cuts are not likely to grow the economy over the long term if government expenditures that are necessary to sustain needed infrastructure suffer, so these deductions and credits are not likely to grow the economy. This is one point on which we can agree.

4) Mitchell: The best tax would be "somewhere between A (zero taxation) and B (turning point where rate is too high and revenues go down with higher rates). The best would be a "simple and fair" flat tax.

Of course, if there were a single point that represents a "too high" tax rate, then it would clearly be preferable to keep the rate below that rate. Many issues would come into play, such as the need for revenues and the use of tax policy as an incentive or disincentive for behavior. If there were a known mathematical formula that would produce a Laffer curve and thus give us an easily quantifiable understanding of the relationship between tax rates and revenues, then it would be somewhat simpler to set tax policy by considering that formulaic relationship. But since there is no formula that produces the "Laffer Curve" and thus no formula that provides an objective answer for tax changes in context, this is nothing more than a general common sense statement that one doesn't want taxes to become so high that they can be expected to substantially distort people's economic decision making. Just based on what we intuit about human nature, we can probably assume that rates around the 80% or 90% rate and higher are likely to have that kind of impact. You don't need the speculative Laffer curve to make that assumption. In fact, the Laffer curve's speculative nature adds nothing to that insight.

As far as the "best tax is a flat tax" statement, that is simply not demonstrated and is most likely wrong. When fairness and other considerations are taken into account, a flat tax creates enormous concerns, especially because of the harmful distributive effects at the lower end of the income distribution and the harmful effects on democratic institutions because of the minimal taxation on the incomes of those at the high end of the distribution.

Comments

CFP's Laffer Curve Video

The "Center for Freedom and Prosperity" (CFP) is a libertarian think tank that promotes a flat tax and very low tax rates. One of their prominent commentators, Cato Institute fellow Dan Mitchell, now has a video out purporting to explain the "facts" about the so-called Laffer Curve theory that tax cuts can increase tax revenues. Art Laffer, the "inventor" of the Laffer Curve diagram (if you can call a speculative bell-shaped curve drawn on a napkin an invention), calls the video "a great common sense tutorial that shows the real relationship between tax rates, taxable income and tax revenue." You can read the Center's release about the video at this link and view the video at this YouTube link.

I suspect that people who watch the video may be seduced by the apparent matter-of-fact "explanation" provided. But the Laffer Curve is simply the result of "supply-side" "trickle down" economic speculation useful for arguing for reduced taxation of the capital gains of the elite.

Mitchell points out one real fact to start out: if there is a zero tax rate, the amount of revenue taken in will be zero. Nothing else is established fact.

To establish the other end of the Laffer curve, Mtichell then states that a 100% tax rate will result in zero revenue. We can agree that in many cases a 100% tax rate would result in zero (or close to zero) tax revenues because we expect that most people would not be willing to work solely for the public good without any benefit for themselves. But that depends on an underlying assumption that the "base" being taxed is all economics from all transactions. In fact, that is not the base that is currently taxed (gifts are left out, municipal bond interest is left out, etc.). A 100% tax rate is therefore meaningless without some sense of the base that is being taxed. 100% of one half of my income is not so onerous, whereas 100% of 80% of my income seems more so and 100% of 100% of my income would be terrible (depending, of course, on the definition of "income'). The fact is, it is impossible to address the relationship between rates and revenues meaningfully without simultaneously specifying tax base and taxable periods (and even something about duration of the particular provisions). Moreover, the Laffer curve conclusion at the 100% rate also assumes that the taxpayer is getting no reasonably commensurate benefit from the government's capture of 100% of the funds otherwise earned by the taxpayer. In a socialist system, it is quite possible that the taxpayer would receive a magnificent standard of living provided by the state, which would turn the assumption on its head. Even in a capitalist system, It might also be possible to apply a temporary 100% rate, slated to return shortly to "normal" rates, over a single taxable period that would result in a huge leap in tax revenues, rather than zero revenues, where the government is understood to be motivated by an extraordinary national disaster in which all of the revenues collected will be put to the benefit of all of the citizens, in a way that individual citizens could not do under the circumstances. In other words, people in the US might be willing to work entirely for the government over a very limited time period in very limited circumstances. That is an extreme (and extremely unlikely) situation, but so is the idea that the government would ever seek 100% taxation or the conclusion that a 100% tax rate would result in no revenues whatsoever. Thus, Mitchell's statement of these various assumptions as "facts" is clearly inappropriate, since he fails to address these questions of base or time period or provision of public goods from the taxed revenues.

After purporting to establish these two "zero" endpoints, Mitchell proceeds to state (again as uncontroverted fact) that there is a single peak tax rate (the peak of the curve) that is so high that any rate higher than that will lead to more cheating, so that this peak rate is the last point where increases in tax rates can lead to increases in tax revenues. Mitchell provides as an example the 70% rate in effect when first Reagan tax cuts were installed--he claims that rate was over the peak and so led to too much tax cheating and not more revenues. Mitchell then leaves the rise and fall from that optimum as "obvious" given the endpoints and the stated peak, thus "explaining" the familiar bell-shaped Laffer Curve.

Of course, none of that is necessarily true. First, consider whether there is a single "peak" rate. There might be two peak rates in some situations--one at the low end and one at the high end--or several local peaks. There might be one fairly high peak rate with a fairly straight-line slope up to it and then a precipitous drop-off beyond that rate. furthermore, there might well not be a steadily rising relationship of rates to revenues or a steadily falling relationship at any point in the curve: the "explanation" provides no evidence to support the suggested concave shape of the curve, the assumption of continuity, or the establishment of an optimal tax rate: it merely presents a visual image as the correct answer. Different cultures and different groups of taxpayers within a culture will undoubtedly respond differently to different economic stimuli, including tax reductions or increases. The "laffer curve" represents merely one highly speculative conclusion about those responses, based on a static model that doesn't take the dynamic nature of economies, labor supplies, basic human needs, and tax systems into account.

Furthermore, in this discussion, Mitchell completely disregards a critical issue in terms of what rates are administratively feasible--the nature of tax enforcement. He never addresses the relationship between tax cheating, tax revenues, and tax enforcement. For any tax rate, the likelihood of compliance is likely substantially higher if there is better tax enforcement and the likelihood of cheating is higher if there is ineffective tax enforcement.

The visual image--Laffer's hypothesis about the relationship of tax rates to revenues, drawn on a cocktail napkin during a conversation--is then treated as a firmly established empirical fact from which various conclusions can be drawn. Mitchell proceeds to "explain" that a tax rate increase from the 15 to 20% range would bring in more revenues than a tax rate increase from the 25 to 35% range, because it is in a "lower" part of the ascending section of the Laffer bell-shaped curve and not as close to the peak where the slope of the curve is much less steep (as drawn). But the speculative nature of the Laffer curve, as described above, and the fact that it does not stem from objective observations that resulted in a substantiated mathematical formula producing the curve, means that it cannot serve as a basis for reaching real conclusions about relative merits of competing tax rates or other tax policy concerns.

Finally, we still have an inadequate understanding of the elasticity of work in response to taxes (especially given the relative inelasticity of labor supply), yet conclusions about that issue are essential to the Laffer Curve. Some people undoubtedly work more as taxes go up, some people may work less, and many people may not adjust their work at all to changes in tax rates. Some might work no matter whether there is 0% or 100% taxation. But again, since tax changes are but one part of a volatile and ever changing economic and cultural landscape, it is likely that tax rate cuts are merely one factor in overall work decisions.

Among the various conclusions stated in the video:

1) Mitchell: We "know" that there is a Laffer curve showing the relationship between tax rates and tax revenues.

Beale: Yes, there is some relationship between rates and taxes, at different points in time, that can be empirically determined and graphed. But it is not necessarily the particular relationship depicted by the "Laffer curve." And it is not necessarily a relationship that remains constant over time.

2) Mitchell: Although all tax cuts do not pay for themsleves, there is "pretty good evidence" that the Reagan rate cuts paid for themselves and that cuts in capital gains rates increase receipts.

Much of Reaganomics is myth rather than reality. The Reagan tax cuts in 1981 were followed by tax increases and then major reform to address the proliferation of loopholes. There were huge deficits because the Reagan tax cut was combined with huge defense spending. Our national debt began to balloon as a percent of gross domestic product, after years of gradually paying off the World War II debt. See this link for a great graph. Even looking at the 1986 reforms, it is clear that the Reagan rate cuts of 1986 were accompanied by significant base broadening and loophole closing. To attribute increased revenues to rate cuts is to disregard the impact of base broadening. If the Reagan rate cuts had taken place without the base broadening, tax revenues would almost certainly have decreased significantly.

Cuts in capital gains rates may tend to increase receipts (when they do) in large part because those who hold significant capital assets expect the cuts in rates to be followed by increases in rates (as has been the trend over time) and therefore choose to take advantage of lower rates to harvest losses and gains in ways that minimize their tax liabilities. That does not mean that, over the long term, cuts in capital gains rates will increase tax revenues. Much of the statistical evidence on this is highly selective--i.e., there is no objective and invarying response to capital gains tax cuts, but people who support them may claim that they increase revenues by waiting until whatever point after a capital gains cut there is some shift in the realization of capital gains resulting in increased revenues and then claiming (without much support) that the shift was caused by the rate cut.

The CBO study of Laffer curve effects also came to a significantly different conclusion than Mitchell does. Under differing assumptions about work responses to rate changes and foreign investment, it found that a 10% tax cut would only partly be made up with increased growth (ranging from 5% to 32% in the second five years after the cut), whereas the shortfall of revenues would lead to increased borrowing, resulting in substantially increased costs for the same governmental programs already deemed important. See Analysing the Economic and Budgetary Effects of a 10% Cut in Income Tax Rates, CBO, Dec. 2005.

3) Mitchell: credits, deductions and other incentives in the tax code "probably" result in unchanged incentives to work and expand the economy.

There are mixed justifications for, and expectations of, these various tax changes. Like most tax changes, it is hard to make a cause-and-effect determination because they are not enacted in isolation and any conclusions are highly speculative. Many deductions and credits are enacted to reward special interests with a "tax expenditure" type of welfare. Just as tax cuts are not likely to grow the economy over the long term if government expenditures that are necessary to sustain needed infrastructure suffer, so these deductions and credits are not likely to grow the economy. This is one point on which we can agree.

4) Mitchell: The best tax would be "somewhere between A (zero taxation) and B (turning point where rate is too high and revenues go down with higher rates). The best would be a "simple and fair" flat tax.

Of course, if there were a single point that represents a "too high" tax rate, then it would clearly be preferable to keep the rate below that rate. Many issues would come into play, such as the need for revenues and the use of tax policy as an incentive or disincentive for behavior. If there were a known mathematical formula that would produce a Laffer curve and thus give us an easily quantifiable understanding of the relationship between tax rates and revenues, then it would be somewhat simpler to set tax policy by considering that formulaic relationship. But since there is no formula that produces the "Laffer Curve" and thus no formula that provides an objective answer for tax changes in context, this is nothing more than a general common sense statement that one doesn't want taxes to become so high that they can be expected to substantially distort people's economic decision making. Just based on what we intuit about human nature, we can probably assume that rates around the 80% or 90% rate and higher are likely to have that kind of impact. You don't need the speculative Laffer curve to make that assumption. In fact, the Laffer curve's speculative nature adds nothing to that insight.

As far as the "best tax is a flat tax" statement, that is simply not demonstrated and is most likely wrong. When fairness and other considerations are taken into account, a flat tax creates enormous concerns, especially because of the harmful distributive effects at the lower end of the income distribution and the harmful effects on democratic institutions because of the minimal taxation on the incomes of those at the high end of the distribution.